Hot Money bringing down U.S. banks -- and Iceland

Banks that are not deemed too big to fail are failing fast -- the FDIC has overseen 52 failures so far this year. And one of the biggest causes of these failures is what's called Hot Money -- high rate deposits gathered by brokers from around the country (if not the world). The 79 U.S. bank failures in the last two years had four times the brokered deposits of the average bank, and 33 percent of the failed banks had high brokered deposits and extremely fast growth.

Why does Hot Money cause bank failures? Those deposits pay rates of return that are around 20 percent higher than the average so huge amounts of money flow to the highest paying banks -- and when those banks get in trouble and can't keep up, the money flows out of them just as fast. But the rapid growth in deposits leads banks to apply Say's Law, the economic notion that supply creates its own demand.

For banks, the new supply of deposits, creates big demand to lend it out. How so? If a bank pays deposit rates of 5.25 percent, it is going to lose money unless it can make loans at an even higher rate. So the influx of Hot Money forces lenders to make lots of risky loans on which it can charge higher rates. Security Bank (SBKC), near Atlanta, boosted its brokered deposits from $693,000 in 2000 to $798 million in 2008 -- paying 5.28 percent interest, or 20 percent higher than what local banks paid their customers.

It used the money to buy raw land and construct housing developments. During the real estate bubble build-up, those loans brought higher profits from fees and higher interest rates -- and by 2007 they accouned for 53 percent of Security's loan portfolio.

One example -- Security financed Highlands, a now bankrupt project to convert 230 acres of a former plantation into an upscale new neighborhood. Now Security Bank is in trouble with the FDIC -- after losing $254 million in 2008 and suffering a 92 percent collapse in its stock in the last year.

Hot Money has been a problem for decades in the U.S. William M. Isaac, chairman of the FDIC from 1981 to 1985 -- who I worked for as a consultant in 1982 -- tried to eliminate FDIC insurance for Hot Money after watching the 1982 collapse of Oklahoma City's Penn Square bank which had gorged on brokered deposits. But Isaac's effort to do that provoked an industry revolt and was ultimately overturned.

And the same forces protecting brokered deposits then are at work trying to protect them today. This protection allows listing services -- which let banks get around regulations requiring banks that take brokered deposits to pay higher FDIC insurance rates -- to prosper. One example is QwickRate, based in Marietta, GA -- with just 18 employees -- which delivered $1.6 billion in Hot Money to banks in May 2009, up from $450 million the year before.

Hot Money is a problem around the world. Last October it helped bring down the banking system of an entire country -- Iceland (population 300,000) -- by attracting huge amounts of British and other foreign deposits to its largest banks by paying higher interest rates on deposits.

Landsbanki, then one of Iceland's biggest banks, attracted $7 billion to its IceSave accounts that way from 300,000 British retail investors. To pay those higher rates, Iceland's banks lent out those deposits in risky projects around the world which paid even higher interest rates.

But with September 2008's collapse of various U.S. financial institutions including Lehman Brothers, those Hot Money providers got nervous and started withdrawing their money. Iceland's banks suffered a cash crunch and the Icelandic government nationalized them.

Brokered deposits are a bad idea and should be banned. But so far nobody has been able to fight the power of the brokered deposit lobby.

Peter Cohan is president ofPeter S. Cohan & Associates. He also teaches management at Babson College. His eighth book isYou Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing. He has no financial interest in the securities mentioned.

Read Full Story
  • DJI26770.20-255.70-0.95%
  • NIKKEI 22522492.6840.780.18%
    Hang Seng26719.58-128.92-0.48%
  • USD (PER EUR)1.12-0.0009-0.08%
    USD (PER CHF)1.02-0.0004-0.04%
    JPY (PER USD)108.400.05000.05%
    GBP (PER USD)1.29-0.0045-0.34%